Bernanke Statement before Financial Crisis Inquiry Commission (2010) Vaughan / Economics 639 1

Triggers vs. Vulnerabilities Triggers – particular events or factors that touched off the crisis. Vulnerabilities – the structural weaknesses in the financial system and in regulation/supervision that propagated and amplified the initial shocks. 2

Triggers Major Trigger (i.e., most prominent) – prospect of significant losses on residential mortgage loans to subprime borrowers that became apparent shortly after house prices began to decline. Minor Trigger – “sudden stop” in June 2007 in syndicated lending to large, relatively risky corporate borrowers. 3

Vulnerabilities – Private Sector Dependence of “Shadow Banking System” on unstable, short-term, wholesale funding. – “Shadow Banks” – financial entities other than regulated depository institutions that serve as intermediaries to channel savings into investment. – Securitization vehicles, ABCP vehicles, money market funds, investment banks, mortgage companies, etc. are part of the shadow banking system. – Reliance of shadow banks on short-term uninsured funds made them subject to runs (which, in turn, led to “fire sales” of assets). 4

Vulnerabilities – Private Sector Deficiencies in risk management and risk controls. Examples include: – Significant deterioration in mortgage underwriting standards before the crisis (not limited to subprime borrowers). – Similar weakening of underwriting standards for commercial real estate. – Excessive reliance by investors on credit ratings. – Inability of large firms to trace firm-wide risk exposures (including off-balance sheet). – Inadequate diversification by major financial firms. 5

Vulnerabilities – Private Sector Excessive leverage by households, businesses and financial firms. Derivatives: – Throughout the crisis, virtually all derivatives contracts were settled according to their terms (i.e., without incident). – Credit derivatives (credit default swaps or CDSs) were a problem. AIG took large positions without hedging or providing adequate capital. 6

Vulnerabilities – Public Sector Statutory framework of financial regulation in place before the crisis contained serious gaps. – Most shadow banks were not subject to consistent and effective regulatory oversight (special purpose vehicles, ABCP vehicles, hedge funds, nonbank mortgage origination companies, etc.). – Some shadow banks were subject to prudential oversight but it was weak/inadequate (investment banks, AIG) – Result: lack of data that could have revealed risk positions/practices. 7

Vulnerabilities – Public Sector Regulation/supervision focused on safety-and- soundness of individual firms/markets, not on systemic risk. Poor oversight of Freddie/Fannie. – Were allowed to grow rapidly (in part through purchases of subprime MBSs) with inadequate/poor quality capital. Ineffective Use of Existing Authority (especially by bank regulators) – Concrete profits vs. “ bad feeling” 8

Vulnerabilities – Public Sector Weak Crisis-Management Capabilities. – In contrast to the regime in place for depository institutions, no one in the U.S. government had legal authority to resolve failing nonbank financial institutions (including bank holding companies) in a way that would impose appropriate losses on creditors while limiting systemic effects. “Too Big to Fail” – Causes moral hazard. – Gives competitive edge to large firms over small firms. – TBTF firms can become systemic threats. 9

Causes of Housing Boom Not monetary policy. Feedback loop between optimism regarding housing prices and innovations in the mortgage market. High rate of foreign investment in U.S. (savings glut). 10